By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.
Wide swaths of families, businesses, investors, taxpayers, and others have had not just their net worth but their lives damaged by the recent financial crisis and its aftermath. Many are looking for an explanation. Many are content to attribute blame and much anger has been directed at Wall Street firms, the credit rating agencies and increasingly the Fed. However, I find ironic that the Fed is escaping criticism for egregious policy errors, while being blamed for decisions and actions that were precipitated by the failure of other agencies to shoulder their responsibilities.
Errors for which the Fed should be held accountable, but for which it has largely escaped criticism, include the following:
• The Fed managed to completely miss the housing bubble. It continues to argue that it should not be held accountable for missing the housing bubble because no one saw the housing bubble, when in fact many knowledgeable and well-respected analysts and policy makers, inside as well as outside the Fed, called attention to the bubble.
• The Fed adopted a macro-economic framework for policy analysis that systematically underestimated (i.e., ignored) the importance of financial markets and institutions to policy and economic performance. Not surprisingly, it ignored its supervisory regulatory responsibilities.
• The Fed allowed increased concentration in the financial services sector, which implied the growth of TBTF institutions, concentrations of market power, and informational asymmetries that are inconsistent with fair and well-functioning markets.
• The Fed publicly and repeatedly claimed credit for the great moderation. The view that it could produce trend growth in low inflation and interest rate environments, coupled with the low-and-slow-to-tighten interest rate policy contributed to an atmosphere in which financial institutions and households believed that there was no risk in highly leveraged positions.
• The Fed temporarily masked the costs of the decline of the tradable goods sector (in part a reflection of a dysfunctional exchange system) while at the same time ignoring its responsibility as the bank of issue of the world’s reserve currency.
• The Fed failed to learn from the LTCM crisis. In fact, the current crises can be accurately viewed as the LTCM crisis repeated on a nationwide scale.
• The Fed dismissed critics who charged that excess liquidity was fueling asset price bubbles, arguing that the liquidity was 1) a vague concept, 2) impossible to define, and 3) impossible to measure. In short, the Fed argued that liquidity could not be used as a policy tool. However, once the crisis broke, the Fed immediately made what had previously been indefinable the focus of policy. Furthermore, it knew how to allocate the liquidity by type of counterparty and collateral. Unfortunately, the problem of excess liquidity had already morphed in to a solvency crisis.
• Most importantly, the Fed failed to achieve the target it set for monetary. Starting in the mid-1990s, the Fed assured the public that it would use monetary policy to prevent the US from experiencing the problems that had beset Japan. Unfortunately, the US is repeating the Japanese experience: a stock market bubble, a real estate bubble, the collapse of the financial system, a recession (by many measures the worst since the Great Depression), unemployment, a ballooning of the fiscal deficit, and inflation low enough that the Fed was forced to adopt unconventional policies that resulted in its balance sheet doubling. (Short version: the Fed learned nothing from the Japanese experience.)
• The Fed has also exhibited a profound political naiveté. It allowed itself to become a political punching bag. This will compromise its ability to set policy with an eye to longer-run developments just when the political demands on the Fed will rise as the scale of the debt and deficits crimp fiscal policy.
The Fed role in the AIG fiasco straddles the fence. The Fed made a one decision that was a major blunder, but many of the criticisms directed at the Fed also reflect the errors and failures of others.
Post-Bear and the GSES, the Treasury should have prepared contingency plans to be used in the event of crises at systemically important firms, e.g. AIG and Lehman. Instead it simply waited until there was “blood in the street”. The Treasury abdicated its responsibilities.
The Fed had absolutely no business substituting itself for the executive and legislative branches of government by “bailing out” AIG. Making a loan based on acquiring a 79.9% ownership interest in the borrower is not a loan—I don’t care what the Fed lawyers opined at the time any more than I care about what E&Y opines about Lehman’s 105 repos. The Fed assuming indirect operational control of any company, especially an insolvent one, was a bridge too far. Assuming a bailout was necessary, the de facto nationalization or resolution of AIG should have been accomplished de jure under terms and conditions approved by Congress and the President, as was the case with the GSEs and the auto makers.
Given the speed of developments, it may have been incumbent on the Fed:
1. to have temporarily financed Treasury’s acquisition of AIG while Treasury sought the enabling legislation; or
2. to have lent Treasury the funds to meet AIG liquidity needs contingent on Congressional approval and funding of a resolution vehicle; or
3. to have taken steps to relieve the pressure on AIG while Congress and the President established the legal framework to nationalize and or unwind AIG.
However, the Fed should never have agreed to take an ownership interest in (even if placed in a Trust) and exercised any degree of management control over AIG.
If the Fed had limited its role to the temporary financing of the AIG bailout (much as it provided financing until Congress created the GSEs conservatorships), then decisions made about AIG, including treatment of its various creditors and the payment of bonuses would have been in the hands of the Executive and Legislative branches of government where they belonged.
The Fed was and is not a bankruptcy court. Congress or an entity explicitly authorized and appropriately empowered by the Congress should have been designated to deal with AIG and the issues such as the payment of bonuses and payouts by the clearly insolvent AIGFP. The Fed had no business adjudicating claims or arbitrarily imposing haircuts on AIGFP’s creditors, counterparties, or other claimants. If senior status was to be granted to investors in AIGFP’s GIAs relative to CDS counterparties or other claimants, it is up to Congress to decide and the courts to enforce. Note that AIG is the only company that the Fed is “resolving”. The Fed wasn’t chosen as the conservator of the GSEs. The Fed wasn’t chosen as the vehicle to revive GM and Chrysler. The Fed doesn’t even unwind failed banks.
The Fed should never have put itself in a position where it could be called upon to use public money to make any of a bankrupt firm’s creditors whole without authorization and appropriation from the Congress.
The Fed made a series of errors, but they were precipitated by the failure the Treasury to act and presumably the inability of Congress to make a decision in a timely fashion. The Fed should have had the backbone to just say NO to the then-Secretary of the Treasury Paulson when it was asked to bail out and assume control of AIG. Treasury had stepped up and bailed out the GSEs (with temporary Fed-supplied financing). The Treasury also arranged guarantees for money market funds. Why was it the job of the Fed to bail out and unwind an insolvent insurance holding company and assorted subsidiaries?
If the Treasury and the Congress had been up to their responsibilities, the Fed would not have had to abandon its lending function whereby it makes overly collateralized recourse loans to solvent firms.
In short, the Fed should be criticized and admonished for foolishly exceeding its legal authority. The Fed made decisions and some of them have proved to be unpopular. However, two-plus years after Bear we still do not have a law providing a framework for resolving financially impaired systemically important firms. What kinds of decisions, if any, would the Congress have made in the middle of the AIG crisis? We know that Treasury was incapable of planning a response to a crisis and ducked responsibility for difficult and potentially politically costly decisions. The Fed should have stepped aside, but instead it stepped up and made some decisions which have proven to be unpopular. Would Paulson have made better decisions? Could Congress have made a decision?
The failure of Lehman is in the headlines once again. Not surprisingly, the Fed is in the cross hairs of numerous commentators. I am not surprised. The free ride given to the SEC does surprise me. The SEC failed in regard to Bear. It failed in regard to Merrill. It failed in regard to Madoff. It failed in regard to Lehman. The SEC was Lehman’s regulator. While on the SEC’s watch, Lehman became a large, complex, grossly overleveraged securities firm with a concentration of illiquid under-performing assets and dodgy bookkeeping.
Where is the outrage at the SEC? The only mention of the SEC in the summaries of the Dodd financial reform bill that I read was funding for the SEC independent of Congressional appropriation. It seems the only thing that the SEC succeeded at was lowering its performance bar to the point that a snake would trip over it. On the other hand, the Fed is portrayed by many critics as an omniscient, omnipotent, Machiavellian operative responsible for all that is less than optimal. (This is in stark contrast to some at the Fed who believe the Fed to financial market version of a comic book super hero: incapable of doing evil, i.e. Fed policy cannot possibly have unwanted unintended negative side effects and undesirable outcomes must be somebody else’s fault.)
Critics charge that the Fed should have made public the fact that Lehman was insolvent. Given that the Treasury had decided not to develop or propose a means to deal with failures of systemically important non-banks until after a crisis had occurred, any such announcement would have precipitated the crisis we all rue. Historically, the bank regulators have acted to minimize both potential market disruptions and the cost to the insurance fund/taxpayers. This was the modus operandi behind the JPMorgan/Bear and BOA/Merrill mergers. The fact that the Fed and the SEC said nothing while Lehman continued to shop itself should not be newsworthy.
Many charge that the Fed should have also independently taken steps to avoid the disorderly unwind of Lehman, but many of the same critics take issue with decisions and choices made at AIG even though Lehman would have been AIGFP in spades.
A frequently cited reason for Fed involvement in AIG is that Congress could not have put together a rescue plan in a timely fashion as it did for the GSEs; however that is really an additional reason for the Fed to have refrained from getting involved in AIG. The Fed is not empowered to substitute its judgment for that of the President and the Congress.
It is inconsistent and hypocritical to charge the Fed with being undemocratic while requiring it or expecting to take actions outside its legal mandate. If the Fed is to be a democratic institution, it must constrained by its legal mandate at all times. It cannot violate its mandate simply because it deems it expeditious; it cannot assume the role of a bankruptcy judge; it cannot usurp the role of the Congress by distributing public monies. On the other hand, if you want or approve of the Fed exceeding its mandate and taking extra-legal actions by performing functions mandated to other agencies, or the courts, or the taking it upon itself action to fill loopholes in legislation on-the-fly, then you must cede that the Fed will be anti-democratic.
Criticize the Fed for failing to deliver financial and economic stability. Criticize the Fed for failing to discharge its responsibilities as a regulator. Criticize the Fed for foolishly exceeding its mandate. Criticize the Fed for assuming responsibilities for which it was not designed and ill-prepared. Criticize the Fed for permitting itself to be turned into an off balance sheet Treasury Department SIV. Criticize the Fed for charging in to a political mine field. The Fed deserves it
Limit criticism of the Fed for not being what it was never designed to be: a means to unwind/resolve financially troubled, systemically important firms.
Don’t criticize the Fed for having exceeded it legal mandate in the case of AIG and then criticize it for not exceeding its legal mandate in the case of Lehman (or vice versa).
Criticize the Fed for its role in AIG, but keep it in perspective. Whatever the costs to society and the taxpayer of the mistakes the Fed may have made in the AIG fiasco, they are small change compared to the cost of the Fed’s inappropriate monetary policy, the Fed’s ignoring its regulatory responsibilities, etc. In addition, compare the cost to society of any Fed errors at AIG with the costs of Treasury and Congressional inaction and/or their hasty decisions if the Fed had not assumed control of AIG.
Criticize the Fed, but keep in mind the relative costs of all the mistakes and failures to act by all the participants.